A Quick Guide to Dollar Cost Averaging

Written by Harmony Wagner

As most investors know, it is nearly impossible to predict the perfect time to invest outside cash. When stocks are performing well, investors may be concerned that the market is at its peak; during a market correction, investors may fear how much more it could drop before recovering. The unpredictability of the market can cause people to leave excess cash on the sidelines for months or even years, and potentially missing out on considerable growth. For would-be investors struggling with making that first step, dollar cost averaging can be an effective risk management strategy.

Dollar cost averaging (also known as DCA) describes a systematic investment approach in which cash is invested in a series of fixed dollar amounts (called tranches) at regular intervals. For example, an individual with $100,000 in cash to invest might implement a DCA strategy by investing $25,000 on the first of each month for four months. Let’s look at this example in further detail, assuming for the sake of the illustration that the investor was investing in only ABC stock.

Date	Cash Invested	Price per ABC Share on date of purchase	# of ABC Shares Purchased
01/01/2020	$25,000.00	$100.00	250
02/01/2020	$25,000.00	$125.00	200
03/01/2020	$25,000.00	$75.00	333.33
04/01/2020	$25,000.00	$100.00	250
Total	$100,000.00	N/A	1033.33

 

By the time all the cash is invested, our investor would have purchased 1,033.33 shares of ABC stock at an average purchase price of $96.77 per share. If they had invested all $100,000 right away, they would own exactly 1000 shares of ABC which would have cost $100.00 per share. This is an example of how a DCA strategy can provide a benefit to investors during times of market volatility.

There is another layer to dollar cost averaging, which involves taking advantage of any market downturns by accelerating the investment schedule. For example, in our previous example, when the ABC stock hit $75 per share, the investor could have invested the full remaining $50,000.00 in cash at the lower share price, resulting in 1,116.66 shares owned at an average purchase price per share of $89.55.

A key element of a successful dollar cost averaging strategy is having discipline to stick with the plan. Mentally, it can be difficult to put cash to work during a market downturn, but it may help to remember that dollar cost averaging is most efficient when volatility or even a correction occurs at some point during the investment schedule.

Dollar cost averaging should not be approached as a risk-free way to invest. In fact, DCA isn’t always the most efficient way to put cash to work. In cases where the market goes up consistently over the course of the investment schedule, an investor would have been better off investing all the cash from the start. The DCA approach is simply a potential risk management tool for investors who have significant cash to invest and are fearful about experiencing a significant market drop immediately after putting that cash to work. For those individuals, adopting a DCA strategy and sticking to it can provide the peace of mind needed to get cash from earning pennies in a bank account into the market where it has growth potential. Given the right conditions, dollar cost averaging may even offer investors the opportunity to profit from market volatility.